Measuring the dollar–euro permanent equilibrium exchange rate using the unobserved components model

• We model Euro–Dollar equilibrium exchange rate using Unobserved Component models.
• The models incorporate economic fundamentals from 1975Q1 to 2008Q4.
• The exchange rate closely follows the PEER for most of the sample period.
• Significant deviations only occur immediately before/after the euro's introduction.
• The preferred UC models produce more accurate forecasts than a random walk.

This paper employs an unobserved component model that incorporates a set of economic fundamentals to obtain the Euro–Dollar permanent equilibrium exchange rates (PEER) for the period 1975Q1 to 2008Q4. The results show that for most of the sample period, the Euro–Dollar exchange rate closely followed the values implied by the PEER. The only significant deviations from the PEER occurred in the years immediately before and after the introduction of the single European currency. The forecasting exercise shows that incorporating economic fundamentals provides a better long-run exchange rate forecasting performance than a random walk process.